PART 1: OVERVIEW AND FUNDAMENTALS OF THE CANADIAN FINANCIAL SYSTEM
CHAPTER 1: The Study of Money and Banking
FOCUS OF THE CHAPTER
This chapter provides a broad overview of the study of money and banking and a glimpse of some interesting issues on the subject. A brief introduction to the Canadian financial system, and the major themes discussed in the textbook are also provided.
Learning Objective:
dentify in broad terms what the study of money and banking is about
SECTION SUMMARIES
The Essence of Money and Banking
Money and banking is essentially the study of the roles and functions of money in the economy and of financial markets (such as money, foreign exchange, bond, and stock markets) and their interrelationships. This requires studying the financial institutions (such as chartered banks and insurance companies) and other government and regulatory institutions (e.g., central banks), which play an important role in the financial system.
The behaviour of participants in the financial system (household, business, and government sectors) is also studied. Confidence or credibility plays an important role in financial markets.
Money:Money is a medium of exchange. Economists have developed explanations linking the amount of money (money supply) and its changes to interest rates, stock prices, price levels, and economic activity.
The Transmission Mechanism:The means by which the monetary policy affects or may be affected by other aspects of the economy is called the transmission mechanism. According to a well-accepted principle of the transmission mechanism, monetary policy leads to changes in expected inflation and actual inflation, which affect interest
rates. Interest rates affect economic activity. Economic activity, in turn, may impact on monetary policy and money supply. The workings of the transmission mechanism are greatly influenced by the efficiency and innovations of the financial sector of the economy.
Why Study Financial Markets?The markets for financial assets such as money, stocks, and bonds are the financial markets. There are a very large number of financial markets, as there are many different financial assets. As a result, there are many interest rates. The analysis of the behaviour of interest rates and the prices of these assets (i.e., bond prices and stock prices, etc.) may help us to understand the future course of inflation and economic activity.
The Canadian Financial System
Individuals and institutions play an important role in the transmission mechanism. It is important to study how financial institutions operate, how the economic environment influences their decision-making, and how Canadian financial systems compare with other financial systems.
The reduction in government involvement in the financial system during the last two decades, due mainly to the simplification or elimination of regulations (deregulation), is a very significant development in Canada and many other countries. Divisions among the four categories of financial institutions (i.e., chartered banks, trust companies and near banks, insurance companies, and investment dealers) have been crumbling due to increased competition and regulatory reform, prompted largely by financial innovations, the rapid development of computer technology, and the perception of increased volatility in the financial sector. However, these financial institutions still retain some distinct characteristics. In terms of functions, permitted activities, and customs, Canadian financial institutions differ from financial institutions in many countries and from international financial institutions, such as the International Monetary Fund.
Perhaps the most significant change in the recent past is the financing role played by companies such as AT&T and Canadian Tire, which are different from traditional financial institutions. Their entry into the financial system has implications not only for the degree of competition, but also for government regulation. The desire expressed by more traditional banks to branch out into every aspect of finance (e.g., automobile leasing and insurance) has made government regulation a more complex problem.
Are Banks Special?Financial innovations and alternatives to traditional banks are eroding the dominant position of the banks in the financial system; yet they remain a special category of financial intermediaries. Some of the salient functions of banks are to: allow individuals to hold assets in more liquid forms; permit individuals to reallocate consumption; provide a relatively inexpensive way to complete complex transactions; reduce the asymmetric information problem; and offer tools to manage risks more effectively.
The International Dimension
The growing integration of capital markets worldwide (globalization), the nature of the Canadian economy as a small open economy in the world, and the trend towards increased integration of financial transactions and regulations worldwide make it impossible to explore the Canadian financial system in isolation from the rest of the world.
Globalization increases the ability of investors to diversify their portfolios and to access more markets. Under globalization, the markets become larger and more liquid so that they can absorb shifts in demand and supply with less impact on prices than can small markets. However, some potential risks exist, due to reasons such as inter-country differences in rules and regulations.
International financial considerations appear to have great influence on domestic financial conditions in small open economies such as Canada's. The flow of funds from abroad is growing rapidly. Therefore, issues of exchange rate systems and international debt crisis are important topics for Canadian students. International differences in economic performance, in terms of inflation rates, interest rates, and exchange rate volatility, etc., further suggest the importance of the international dimension in financial markets. However, globalization must be managed to mitigate the contagion effects (spillover of financial crises in one country to the other parts of the world).
Public versus Private Finance:Until recently, governments at various levels incurred sizable deficits which were financed by borrowing from domestic and foreign savers. Some believe that these deficits had negative consequences for interest rates, inflation rates, and economic activity. At present, governments are keen on reducing or eliminating deficits and, therefore, are rapidly withdrawing from financial markets. Private sector borrowing has increased at a faster rate.
A Final Word
Students of money and banking must be conversant with the terms, facts, and concepts of the financial industry, the analytical tools used to examine the relationships among sectors of the financial industry, and the relationship between other financial sectors of the economy. A knowledge of economic and financial theories is important in gaining the ability to use analytical tools and an understanding of the issues involved. These theories, of course, are based on assumptions about the behaviour of individuals and firms. These assumptions are a source of much disagreement; yet we would be unable to explain the past and predict the future in a logical manner without these theories.
MULTIPLE-CHOICE QUESTIONS
1. Money and banking may be broadly defined as:
a) a profit-making business in the economy.
b) the study of money and the central banks.
c) the study of money and financial markets.
d) the study of money and the financial system.
2. The Bank of Canada, chartered banks, and the International Monetary Fund
a) are financial markets.
b) are government institutions.
c) can be considered financial institutions.
d) do not have anything in common.
3. In the world economy, Canada is
a) the largest closed economy.
b) the largest open economy.
c) a small open economy.
d) a large open economy.
4. In the late 1990s government borrowing decreased because
a) the government financed budget deficits by printing money.
b) lenders stopped lending to the Canadian government.
c) the government deficit decreased.
d) the government used accumulated surpluses from the early 1990s to finance deficits.
5. In Canada, during the 1980s and 1990s
a) both household and business sector borrowing increased.
b) both household and business sector borrowing decreased.
c) household borrowing increased, while business sector borrowing decreased.
d) household borrowing decreased, while business sector borrowing increased.
6. The process by which the monetary policy affects the rest of the economy is referred to as
a) the money multiplier.
b) the multiplier effect.
c) the transmission mechanism.
d) the monetary policy.
7. Historical data show that money supply and real GDP are
a) not related to each other at all.
b) negatively related, because money supply generates inflation.
c) positively related over time.
d) identical at all times.
8. Economic and financial theories are
a) of no help because they are based on assumptions.
b) special because no assumptions are made in their development.
c) of great help in predicting the future in a logical manner.
d) not useful to the study of money and banking.
9. Money growth and interest rates
a) are linked through inflation in the transmission mechanism.
b) are not linked in any way.
c) are linked because they affect each other directly.
d) have always increased over time.
10. One of the most important developments in many industrial countries during the last two decades is
a) increased government involvement in the financial industry.
b) the simplification or elimination of government regulation.
c) an increase in the relative importance of chartered banks.
d) strong resistance to globalization.
PROBLEMS
1. Is it important to study money and banking? Explain why.
2. Is there a connection between monetary policy and economic activity? If your answer is yes, explain how they are connected. If no, explain why.
4. Briefly describe important developments in the recent past in the Canadian financial system.
ANSWER SECTION
Answers to multiple-choice questions:
1. d (see page 2)
2. c (see page 2)
3. c (see page 13)
4. c (see pages 11, 12)
5. a (see pages 11, 12)
6. c (see page 3)
7. c (see page 4)
8. c (see page 11)
9. a (see page 5)
10. b (see page 7)
Answers to problems:
1. Yes. Broadly defined, money and banking is the study of monetary aggregates and the financial system. The financial system is made up of financial markets (such as money, bond, and stock markets); institutions such as chartered banks and near banks; household, business, and government sectors which act as savers (lenders); and borrowers. Other government and regulatory institutions such as central banks also play an important role in the system. The financial system is an integral part of the broader economic system and, therefore, the study of money and banking is necessary for a complete understanding of any modern economy.
2. Yes, there is a connection between the monetary policy and economic growth. How the monetary policy affects economic activity has been a matter of debate in economics for some time. Economists have been able to establish a possible mechanism (or process) by which monetary policy affects other factors of the economy. This process is referred to as the transmission mechanism. According to this mechanism, changes in the money supply affect expected/actual inflation, which, in turn, affects interest rates. Changes in interest rates affect economic activity, completing the transmission mechanism.
3. Globalization is the worldwide growing integration of markets, financial markets in particular. Globalization has important implications for financial markets, financial institutions, and regulatory institutions in the financial system. Globalization combined with deregulation has allowed the broader participation of foreign financial institutions. Financial markets have become larger, and able to absorb demand and supply shocks in the markets with relatively less impact on asset prices. The flow of funds in the financial system is strengthened as the access to foreign funds increases. The ability of investors to diversify their portfolios is also increased. Globalization exposes the financial system to both positive and negative changes in world financial markets. As a result, the spillover effects of financial crises from one country to the rest of the world (contagion effect) become more frequent and more consequential for the world economy.
4. One of the most significant recent developments in the Canadian financial system is the reduction in government involvement. This reduction is a direct result of deregulation. Regulatory reforms and increased competition have led to the erosion of divisions among the four categories of financial institutions; namely, chartered banks, near banks, insurance companies, and investment dealers. The rising importance of the financing role played by businesses such as Canadian Tire, not traditionally known for the provision of financial services, is another important development.
Page 1 of 6
Copyright © 2004 McGraw-Hill Ryerson Limited